The Great Commodities Debate - Part I

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HardAssetsInvestor (HAI): Welcome, gentlemen. There's an ongoing debate among financial advisors about
the usefulness of commodities in a long-term asset allocation. Most of the debate centers on returns. Can
commodities, like equities, be reasonably expected to offer a return for a portfolio?
Rick Ferri: Physical commodities, of course, are uninvestable unless you own oil storage tanks and grain bins.
Research published by Erb and Harvey in "The Tactical and Strategic Value of Commodity Futures" indicates
that commodities futures' real expected return-that is, the return net of inflation-is actually zero.
Erb and Harvey show that trading strategy is the sole source of returns in commodity futures indexes. In other
words, it's the way an index provider constructs and rebalances an index that hypothetically created real returns
in the past. Unlike stocks and bonds, simply buying and holding a diversified basket of futures contracts does
not create real returns.
Larry Swedroe: It's true that commodities themselves have no expected real return. That's a pretty good reason
to avoid investing in them. However, collateralized commodity futures, or CCFs, are another story.
The PIMCO Commodity Real Return Strategy fund, as an example, has total costs of about 1%. The portfolio
managers use Treasury Inflation-Protected Securities (TIPS) as collateral to support the embedded commodity
index derivatives. The real return on TIPS is about 2%, so the PIMCO fund provides a return, net of costs and
inflation, of about 1%. That's above the real historic return of the benchmark one-month T-bill. Unless one
forecasts persistent contango, where futures trade higher than the spot market, one should expect a real return
from the PIMCO fund.
Rick Ferri: PIMCO's use of TIPS may boost returns, but that has nothing to do with commodities. PIMCO's
capitalizing upon the spread between T-Bills and TIPS. Since the T-Bill yield is imbedded in commodity
futures prices, PIMCO is essentially shorting T-bills and buying TIPS. That's interest rate arbitrage, not
commodity investing.
HAI: Financial advisors often point to correlation - or more properly, noncorrelation - as a reason to
include a commodities allocation in a portfolio. Where do you stand on the correlation issue? Would
negative correlations alone be reason enough for an allocation?
Swedroe: Futures, or more specifically, CCFs, are one of the rare asset classes that have negative correlation to
both stocks and bonds. That makes them excellent risk diversifiers. A negative correlating asset acts just like
portfolio insurance because it tends to produce higher-than-average returns when the other asset is producing
lower-than-average returns.
In each of the nine years since 1970 that long-term bonds produced negative returns, CCFs produced positive
returns. The average is about 30%. And, in the eight years of negative stock returns, since then, CCFs produced
positive returns six times, garnering an average gain of 23% for all eight years.
The negative correlation is easily explained and quite logical. CCFs are positively correlated to unexpected
inflation while stocks and bonds are negatively correlated. Hence the very strong performance against bonds.
But CCFs also provide a hedge against event risks. Some event risks such as the oil crisis of the ‘70s impact
stocks and commodities differently. Others, notably 9/11, cause the markets to react similarly. Put simply, if an
event creates inflationary-type recession, then it is good for CCFs but bad for stocks. If an event creates a
deflationary environment, than you'll see the correlation of stocks and CCFs rise.
Negative correlation is not enough reason for making an investment. One should also consider the return. But
the mistake so many people make is considering return in isolation. The question really centers on the impact of
adding the commodity return on the overall portfolio. Harry Markowitz basically won a Nobel Prize dealing
with this issue. He showed that adding risky assets can actually increase returns without increasing risk,
depending on volatility and correlations.
With negative correlation we actually like higher volatility because, with rebalancing, the diversification return
increases. You buy at lower lows and sell at higher highs. Economic theory states that assets with negative
correlation should have less than the riskless return because they act like insurance.
Ferri: It's not correct to say that CCFs are negatively correlated. They've been both negatively and positively
correlated. It really depends on the period measured. There are many periods, such as the last three years, when
the correlation is positive with stocks and bonds. At best you can say correlation varies and is dynamic. That
said, the risk reduction benefits of commodities are period-sensitive.
I think correlation analysis is misunderstood and overused in portfolio management. When a new asset class is
being investigated for unique risk, correlation is a good test. If two separate asset classes have varying
correlation, then there is probably unique risk in those asset classes. Thus, an investor can go to the next level,
which is a return analysis. But commodities fail the expected real return test. That's why I don't include them in
portfolios. The lower expected returns of commodity funds is not a fair trade for the proven real returns of
assets such as stocks.
Low correlation is not, by itself, a good reason to do something. After all, stuffing money in a mattress has no
correlation with stocks and bonds, but I don't recommend doing it.
Swedroe: Of course correlations move over time, Rick. What's key is the long-term correlation. Since
correlations vary, one should look at when they tend-on average-to turn up and down. The historical data
shows the correlations for CCFs tend to turn negative when needed most, especially with respect to bonds.
Ferri: Correlation measures the direction of movement, not the magnitude of the movement, Larry. If one
index returned 0.1% and another returned 1000%, the correlation is perfectly positive. Although the direction
of return any given year may be similar, actual risk and return can differ by many hundreds of basis points.
HAI: The Erb and Harvey paper argued that individual commodity futures may exhibit no real return, but
it left the door open for futures portfolios. Is there, in fact, a diversification effect?
Swedroe: The Erb and Harvey research established that the most reliable part of the CCF return is the
diversification return which they estimate at about 3% to 5% per annum. This figure is not, of course, included
in the estimated return of CCFs themselves.
Here's what I mean. Using simulated data from 1970 through 2006, a 100% equity, globally diversified, "sliced
and diced" portfolio--the kind I recommend in my books--produced a return of 15.9% with a standard
deviation, or risk, of 15%. The S&P/Goldman Sachs Commodity Index (GSCI) returned 11.5% with a standard
deviation of 18.8%.
Now, why would one want to add an asset with higher risk and a lower return to a portfolio?. Well, here's why:
If you added a 5% GSCI position, the portfolio return would have increased to 16% and the standard deviation
would have fallen to 14.3%. Keep in mind, this is based on GSCI; the use of the PIMCO fund would have
almost certainly produced superior returns.
Ferri: As you say, Larry, the data in your example is simulated. The indexes didn't exist in 1970. Erb and
Harvey had to develop their own commodities allocation and trading strategy to come up with that
hypothetical return using back-testing. Returns from CCF indexes are all alpha- based.
Individual commodities and futures on their own have no expected return. It's the index provider's strategy that
produces alpha in back-testing. So the question really is, "Is it a strategy or an asset class?"
You mentioned Harry Markowitz's work on portfolio diversification, Larry. I don't think Markowitz would
agree that a strategy is an asset class.
I'm not refuting your claim of a portfolio effect, but hindsight is 20/20.

Swedroe: You can't say the Erb and Harvey findings are based on a trading strategy, Rick. All they talk about
is rebalancing.
Erb and Harvey found that if you went long when in backwardation and short in contango, you could obtain
incremental returns. Now that's a trading strategy. I prefer to not follow it because it's not insurance. In other
words, you would be lifting your hedge when the costs go up, like eliminating hurricane insurance after
Katrina. The evidence shows that this has may have been a more profitable strategy in the long run, but there
are many periods when this is simply not so.
The main, if not only, purpose of including CCFs in a portfolio is for insurance. For that reason alone, I don't
like the trading strategy idea. Even if I did, there's currently no investable way to capture the strategy. There's
no retail product based on the strategy available now.
Let me make a distinction here. There is a big difference between data mining and intelligent fund design.
Dimensional Fund Advisors (DFA), a favorite money manager of financial advisors, doesn't include all
securities in their well-respected portfolios; they screen out stocks with penny prices, IPOs and the like. That's
led to superior returns over simple market cap-weighted indexes. The same thing is true here. Instead of a
simple market cap-weighting CCF index, the literature shows that if you create a more equal-weighted index,
you will smooth returns by reducing the negative impact of volatility. That's simply intelligent design, not data
mining.
In addition, if one limited the allocation to commodities that are persistently in high contango and increased
the allocation to those that are more typically in backwardation, the evidence suggests you will get higher
returns. That would also be intelligent design, not data mining. And that is exactly what some of the indexes,
such as the AIG benchmark, has done.
Ferri: Larry, you say that the low correlation of commodity futures to stocks and bonds helps the overall
portfolio. That's only theory, based on hypothetical data. The returns don't include fund fees, which are higher
than those of funds built of stocks and bonds. Let's not forget the trading costs associated with a high turnover
product built of forward contracts.
More important, no one talks about the opportunity cost of taking money from stocks to invest in commodity
index products. Just what is the cost?
There's simply no guarantee that the index you choose will generate an alpha from the investment strateg
The bottom line for me is this: I'm not willing to give up the return from stocks and bonds to invest in an
expensive active strategy that has no expected real return except a hypothetical and inconsistent alpha that the
index provider says it can generate from an investment strategy.
From the standpoint of portfolio risk reduction, commodity indexes have been shown to reduce risk in a
portfolio. The portfolio risk reduction occurs if there is continued low correlation between commodities, stocks
and bonds. In that sense, T-bills also offer portfolio risk reduction because the return of T-bills have low
correlation with the return of stocks and bonds.
But risk reduction is only one side of the equation. The other side is the return element. One must look at how
adding a new asset class will change the expected return of the portfolio before placing that new asset class in
the portfolio. Ideally, an asset will have low correlation and high return relative to stocks and bonds. REITs are
an excellent example. REITs have high expected returns and low correlations. Unfortunately, commodity
indexes offer no such benefit. Aside from a successful trading strategy, commodity indexes do not have a real
expected return.

HAI: Returns and volatilities for domestic equity benchmarks are highly correlated to one another. Are
commodities benchmarks correlated to a lesser degree? What implications does this have for investment
planning?
Ferri: Commodity indexes cannot be compared to stock and bond benchmarks. The risk and returns of highly
diversified stock and bond indexes fall in very tight groups. The Russell 3000, the Dow Jones-Wilshire 5000,
and the MSCI Total Market Index, for example, are almost identical. That shows the beta of the equity market.
Such is not the case for the commodity market. The long-term hypothetical risks and returns of commodity
indexes are all over the map. Returns are based on index strategies devised to create alpha. As, such,
investment planning using commodity indexes involves a leap a faith that a chosen index strategy will create
alpha in the future.
Swedroe: Rick, commodity benchmarks are highly correlated. The Dow Jones-AIG Commodity Index and
GSCI exhibited a 90% correlation from 1991 through September 2007. They're relatively good substitutes for
one another. The correlation of GSCI to the AIG index is, in fact, tighter than that found between most equity
asset classes like that of small-cap value to large-cap growth, or that of the S&P 500 to MSCI EAFE.
There's a major difference in index construction which favors the more equally weighted AIG index, though.
The AIG index benefits greatly from the low correlation of the component commodities and their high
volatility. It's quite logical that commodities have low correlations to one other. After all, why should gold and
wheat be highly correlated? The low internal correlation and the high volatility lead to a large diversification
return.
Since 1991, GSCI and the AIG index have earned similar annual returns but the AIG index has produced
annualized returns that are about 2% a year higher.
Allow me to explain. Annual returns are based upon a simple arithmetic average, but annualized returns reflect
the growth of an invested dollar. If, for example, Index A returns 20% in one year and 0% the next, its annual
average return is 10%, but its annualized return is just 9.5%. It ends up 20% after two years. If Index B returns
10% and 10%, the average annual return is also 10%, but its total compound return is higher. It's annualized
return is 10%, and after twoyears, it ends up 21%.
The greater the standard deviation, or volatility, of returns, the more negative the impact on annualized returns.
AIG produced higher compound returns because rebalancing lowers standard deviation, thereby minimizing
the risk impact on annual returns.
GSCI is more volatile than AIG and thus the volatility has a more negative impact on the compound returns.
That's why it's important to choose the most appropriate index for a fund to replicate.
The AIG index also uses three-month Treasuries as collateral. TIPS should outperform three-month bills
significantly over the long term, so investors in the PIMCO fund would benefit by perhaps another 1% or so.
Keep these points in mind when looking at backtested data using the older GSCI series. One should never look
at the Commodity Research Bureau (CRB) index series - now renamed the Reuters-CRB Continuous
Commodity Index - when gauging the historical returns of CCFs [collateralized commodities futures], though.
For most of its history, CRB was dominated by agricultural commodities; that has little to do with economic
activity. Thus, those that use that index to draw a conclusion are dealing with a "garbage in, garbage out"
situation.
Ferri: AIG is a different strategy than GSCI, thus the risk and returns are expected to differ. As I said before,
using TIPS is an interest rate arbitrage enhancement strategy in the PIMCO Commodities fund. That has
nothing to do with an investment in commodities.
Ironically, CRB was the only live commodity index around in the 1970s, but there was little alpha generation
in it. Alpha didn't show up because CRB equal-weighted all the component commodities futures. It didn't
overweight energy.
So, because it doesn't prove CCF indexes work, you're going to dismiss CRB, Larry? Perhaps, going forward,
the energy-heavy GSCI will be your next "bad index."

HAI: So, in the end, is there a beta for commodities? And, by extension, an alpha?
Ferri: The Russell 3000, the S&P 1500 and the Dow Jones-Wilshire 5000 all have risks and returns that are
very close. The same is true for the Lehman Aggregate Bond Index and the Merrill Lynch Bond Composite.
Unlike stock and bond indexes, there is no consistency of return or risk among commodity indexes. They're all
over the place. That's because the investment strategies of all the indexes are radically different. An investor in
commodities futures indexes is relying 100% on the active strategy of the index provider. Some commodity
index providers claim their strategies add up to 4% alpha over the average return of commodity futures.
In the long term, commodities can be expected to produce the inflation rate. Thus, commodities have no beta,
unless you want to call inflation beta. All the expected returns of commodity indexes are derived from
investment strategy. Backtesting those strategies has shown hypothetical alpha, but there's no guarantee that it
will persist in the future.
Swedroe: Since they have negative correlation to stocks, commodities' beta is negative with respect to equities.
As for alpha, CCFs probably do exhibit alpha, but that simply shows that the Capital Asset Pricing Model
(CAPM) or even the Fama-French three-factor model does not explain CCFs returns.
By definition, alpha is the expected value of that portion of CCFs return that is not explained by CAPM or the
Fama-French model. Since there's no reason to expect CAPM or Fama-French to work well for CCFs, there's
no reason to expect alpha to be zero. One might call the diversification return "alpha" for the portfolio.
HAI: If one were considering an investment in commodities, from what existing portfolio allocation should
it come? Equities? Fixed income?
Ferri: From both. Since a commodity index strategy is neither a stock strategy nor a bond strategy, the best
way to allocate is to take some from stocks and some from bonds. For example, an investor that is invested
50% in stocks and 50% in bonds should go with a 45% stock, 45% bond and 10% commodity allocation.
Swedroe: If you take the allocation from bonds, you'll raise the expected return and risk of the portfolio. That's
not the reason to consider owning CCFs in my view. I believe that ownership ought to reduce risk. So I
suggest taking the commodity allocation from the equity side, thereby reducing the risk of the overall portfolio.
I'd suggest taking about 5% to 10% of the equity exposure, depending on the risk aversion proclivity of the
investor. The more risk averse, the higher the allocation. The size of the allocation should also be based upon
the level of exposure to the risks of unexpected inflation. Retirees generally have higher risk exposure to
unexpected inflation.
Ferri: I don't agree. Taking only from the stock side reduces the portfolio's expected return considerably
because stocks have an expected real return of 4% to 6% while CCF index products have no expected real
return except an unknown alpha. As such, risk is best reduced by taking half from the stock side and half from
the bond side. If investors want to call commodities a separate asset class, then they should treat it as one with
a separate allocation.
HAI: Are there any other issues investors considering commodities should address?
Swedroe: There are a few other issues. Since commodities provide a hedge against unexpected inflation and
thus the risk of longer-term bonds, adding them to your portfolio allows you to take more risk on the bond side
by extending maturities. This is almost always helpful on the municipal bond side where the yield curve is
typically steeper than that of taxables. If we get long bond risk showing up, the CCF will act as a hedge. If we
get the risks to CCF showing up - that is, deflation - then the longer-term bonds act as a hedge. We might think
of adding CCFs and extending maturities is a bit of a free lunch. Another benefit besides the higher yields is
that you reduce reinvestment risk when extending maturities.

Ferri: TIPS are a government-guaranteed hedge against unanticipated inflation. That's the investment to be
used if one wants to extend bond maturity.
There's a cost to this "free lunch," too. The Vanguard Municipal bond fund's Admiral shares are cheap, costing
about .09% per annum. The annual cost of a commodity fund is at least .75% before taxes. I haven't done the
math, but I'm skeptical about this idea of using CCF index funds in a taxable portfolio.
Swedroe: Another consideration is that CCFs tend to produce very poor returns for a very long time and then
have very short bursts of spectacular returns. It takes a very patient and disciplined investor, willing to
rebalance during those long periods of underperformance and having the discipline to sell into the rallies to
rebalance, to benefit from owning CCFs.
Ferri: That is true. CCFs exhibit many years of low returns with spectacular bursts every 25 years or so.
However, energy and natural resource stocks produce a much smoother ride and provide positive returns even
in down commodities markets. Stock index fund investors benefit more often from the current 15% current
position of the U.S. equity market invested in natural resource stocks. How much more exposure to one
industry do investors need?
Swedroe: Finally, I would add that since we own CCFs as insurance, one should root for CCFs to have poor
returns as long as the poor returns are not a result of persistent contango. We never like to collect on our
insurance. The reason for this is simple: With a negative correlation, when our small allocation to CCFs is
producing below-average returns, the vast majority of our portfolio should be producing above-average
returns.
Ferri: That's very expensive insurance. Not only is the cost for commodity exposure higher, the expected
portfolio return is lowered when it's added, especially if the allocation comes from stocks.
Investors can purchase stock and bond beta very cheaply through market index funds. Investing in commodity
index alpha is much more costly.
Investors who put commodity index products in a portfolio are paying a lot of money to give up proven stock
and bond return beta for the hope of commodity index alpha, the hope that, after fees, alpha stays
noncorrelated with stocks and bond beta. That's a lot of hope.
HAI: Thank you, gentlemen.